Premium Finance Defined
Premium financing involves the lending of funds to a person, company, or trust to pay an insurance premium. Premium finance loans are often provided by a third party, typically a bank, at favorable loan rates. The borrower will be required to pay the interest on an annual basis (some premium finance programs allow you to accrue the interest - see the section below on risks!).
In addition to the interest payments, the borrower will need to put up collateral. The first asset put up for collateral will be the insurance policy. In the early years, the policy values are usually less than the outstanding loan balance. The shortfall is made up with outside assets. This collateral requirement can also be met with a letter of credit from another financial institution.
What is Financial Leverage? According to the Accounting Coach, financial leverage 'refers to the use of debt to acquire additional assets. It further states that its use will control a greater amount of assets (by borrowing money) thereby causing the owner's cash investment to be amplified.
Premium Finance is the application of Financial Leverage to purchase an asset called Cash Value Life Insurance.
Why Premium Finance?
Premium Financing allows the owner to attain a large amount of life insurance without dramatically impacting their cash flow and/or liquidating investments to pay for it. By using 'other people's money', you maintain the use of your cash flow for other needs (ideally where you can earn a higher rate of return than the cost of the premium finance loan).
Premiums for the high face amount, policies that many wealthy individuals require can cost hundreds of thousands of dollars a year. While the client may be worth significantly more than that, they may not have enough liquid capital available to pay such high premiums and may not be willing to liquidate assets to raise the necessary capital. Premium financing allows them to attain sufficient insurance while keeping their assets intact.
Many high-net-worth individuals need life insurance to address legacy planning, business continuation, and tax issues. However, many of these individuals may find themselves in a cash-flow deficit while they still need liquid funds for other purposes and investments. In order for high-net-worth individuals to continue to grow and protect their wealth, they need to take advantage of leverage.
By taking advantage of the low cost of capital, you can optimize your own cash flow while securing the life insurance that you need for your family and/or your business.
What Insurance Product Works Best?
In order for a premium finance program to work, the product used has to satisfy three things:
- Reasonable Costs - the internal costs will impact the growth of the cash values. The cash values will be used to reduce and ultimately eliminate the required collateral.
- Performance or return - the crediting rate coupled with the internal cost is what drives cash value growth. This growth should exceed the cost of the loan by 1 - 2% or more for the strategy to work.
- Exit Strategy - the policy cash values are normally the source of paying off the loan. There can be other options, however—a well designed plan has the ability to pay off the loans right from the policy itself.
Based on the above, only accumulation products are suitable for premium finance (as opposed to guaranteed universal life or term). Although variable universal life (VUL) builds up cash value, lenders will not approve that type of product due to the fluctuations in the market.
This leaves us with only 2 options: Whole Life or Indexed Universal Life. Whole Life does a great job on points 1 & 2 above, i.e. low cost (if you use paid up additions riders), and cash value growth (in excess of today's rates). The major problem with using whole life is the lack of exit strategy. It is difficult to use the policy to pay off the loan using a whole life policy.
For these reasons, typical premium finance strategy will utilize an indexed universal life (IUL) policy. One advantage is that a universal life insurance accumulates cash value that can be used to pay back the loan that was borrowed from the third party.
Risks of Premium Finance
Leverage is a great thing when it works in your favor. However, leverage cuts both ways. The major moving parts in a premium finance transaction is the cost of borrowing and the performance of the policy. Lets look at these two issues separately.
Cost of Capital
Today we are in a low interest rate environment, therefore the cost to borrow is low. The 1 month LIBOR (many finance programs are currently using monthly LIBOR plus a spread) is 1.77% (November, 2019 - source Macrotrends.net). The bank usually adds a spread of 1.5 - 2.0% to LIBOR, so the cost to borrow is 3.27% - 3.77%.
This would mean that as long as the product (net of charges) can return an IRR of 3.77% or higher, you are creating positive arbitrage. LIBOR will vary from month to month. In April of 2014, this rate dropped to a low of .15%! Conversely, in March of 1989 it peaked at 10.06%.
Clearly these are two extreme examples and are several years apart. A more realistic range might be to look at the last 5 years. The low was .15% listed above, with a max of 2.52% in December of 2018. To determine the risk of a premium finance structure, you have to take into account the potential of a rising cost to borrow.
The driving factor in performance of an IUL product is the crediting strategy. The typical design (prior to AG49 and the advent of multipliers) is to credit the return of the S & P 500 subject to a Cap (today's caps are 8-10%) and floor (most floors are 0%). The floors are guaranteed, and the Caps are subject to change.
The setting of Caps in the IUL markets driven by several factors (competitive pressure, profitability, pricing philosophy, etc.). However all carriers are subject to the same economic factors. In order to provide a cap and floor, carriers use the excess over the amount needed to provide the floor guarantee as a budget to purchase options. The greater the returns on the companies general account, the more money they have available for their options strategy (higher caps).
Insurance companies typically invest in fixed income securities (Corporate Bonds and mortgages). If you use corporate bond rates as a proxy for the general account, you will find that rates have and are dropping, putting pressure on lowering caps.
The Moody's Seasoned AAA Corporate Bond Yield in January 2010 was 5.26% and dropped to 3.93% by January 2019, and has continued to drop throughout this year.
Quantifying the Risk
The two drivers listed above (Cost of borrowing & Performance of Policy) is what creates both the benefit and risk of premium finance:
- Positive Arbitrage - Cost of Borrowing is lower than Product Performance
- Negative Arbitrage - Cost of Borrowing is higher than Product Performance
Premium finance works best when you have a 'normal' yield curve - where short term rates are lower than long term rates. Low cost of borrowing, with a higher budget to have a higher cap. Obviously, the flip side is premium finance does not work well when you have an inverted yield curve - short term rates are higher than long term. The cost of borrowing is high, the caps are reduced, and you could be headed into a recession.
To mitigate the risk, you need to plan for the possibility that the cost of borrowing escalates with a reduction in Caps. You also have to monitor the results annually to make sure the plan stays on track.
Who Can Benefit From Premium Finance?
Life insurance premium financing may be a viable alternative for individuals who:
- Believe that keeping their assets invested rather than using them to pay life insurance premiums can help them achieve significantly higher returns over time.
- Are unable to pay the premiums for adequate life insurance coverage due to limited cash flow or the nature of their assets.
A low interest rate environment makes life insurance premium financing an attractive strategy to consider as part of an overall estate plan. While certain risks are inherent in this type of financing, it can be a cost-effective method of funding premiums.
What does this all mean for you and your clients?
Premium Finance brings many benefits when structured properly. These benefits include:
- Leveraging your clients' cash flow to fund needed death benefits
- Maintaining the use of cash flow
- Providing supplemental tax free retirement income
Due to the risks of premium finance, it is important to partner with someone who understands all of the moving parts. In addition to picking the right product, finding the right lender, you need to create a structure that falls within the risk tolerance of your client. And finally, the next challenge is how to communicate its value.
Advisors Resource Company has the experience and expertise to guide you through this process. In addition to premium finance, our Leverage Life Process will give you the tools and confidence to bring other solutions to your clients.